Story #1 – Financial Crisis Rocks Wall Street

After the stock market bubble burst, investors turned to other asset classes such as commodities, credit and real estate which all performed very well from 2003-2006.  The positive sentiment in credit and real estate, along with historically low interest rates, created a boom in residential housing.  But by 2006, the boom became a bubble as mortgage underwriting standards loosened and securitization led to an immense investor appetite which allowed more mortgage loans to be made.

The bubble burst in 2007 as sub-prime mortgage defaults skyrocketed, home sales tumbled and residential housing prices fell.  Large brokerages all over the world were announcing billions of dollars in write-downs on sub-prime mortgage-related assets.  Soon the contagion spread to all sorts of securitized assets:  Collateralized Debt Obligations (CDOs), Structured Investment Vehicles (SIVs), Home-Equity Loan Asset-Backed Securities (ABS) (returns shown below) and many others. 

Some of these assets had been rated AAA, supposedly signifying that they were exceedingly safe investments.  By the end of 2007, many were worthless.  With uncertainty surrounding so many of these assets, people questioned the validity of financial statements coming out of Wall Street.  Exacerbating the problem, the credit market had deteriorated making cash very expensive.  The question became, without easy access to credit and uncertain asset valuations, how can investors know these brokerages are even solvent?

For a time, it looked like the Federal Reserve had re-instilled confidence in the financial system; equity and credit markets rallied significantly after the panic surrounding Bear Stearns was quelled.  However, policymakers could not do anything to ease the collapsing housing market.  The negative cycle continued – rising mortgage defaults and falling home prices caused Wall Street losses to keep mounting. 

By September, solvency questions started being asked about another storied Wall Street firm – Lehman Brothers.  Various acquisition scenarios were whispered throughout the market but a deal could never be reached because there were too many questions surrounding Lehman’s assets and liabilities.  On September 14, it became clear Lehman Brothers would default.  Merrill Lynch, realizing that they would be the next domino to fall, agreed to a purchase by Bank of America.  Over the next few months, several more of America’s most prolific companies would be forced into a merger, rescued by the government or declare bankruptcy – AIG, Washington Mutual, Wachovia, Citigroup, Bank of America, Chrysler and General Motors.

When the dust settled it was America’s greatest financial crisis since the Great Depression.  From 10/9/07 to 3/9/09, the stock market dropped 58% making it the largest bear market since 1930’s. 

But beginning in March 2009, the market did turn.  It was boosted by several large banks who reported profits in the first quarter of 2009.  Asset write-downs were finally shrinking and the housing market was at least stabilizing.  In April and May, the Federal Reserve performed stress tests on all the “systemically important” banks.  The results were much better than expected and helped restore confidence in financial markets.

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